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Chapter 3: Net Present Value & Other Investment Criteria
2018
1 Ibrahim Sameer Bachelors of Business (BF – Mandhu College)
Business Finance
Bachelors of Business
Study Notes & Tutorial Questions
Chapter 3: Net Present Value & Other
Investment Criteria
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Chapter 3: Net Present Value & Other Investment Criteria
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2 Ibrahim Sameer Bachelors of Business (BF – Mandhu College)
INTRODUCTION
The word Capital refers to be the total investment of a company
of firm in money, tangible and
intangible assets. Whereas budgeting defined by the “Rowland and
William” it may be said to be
the art of building budgets. Budgets are a blue print of a plan
and action expressed in quantities
and manners.
The examples of capital expenditure:
1. Purchase of fixed assets such as land and building, plant and
machinery, good will, etc.
2. The expenditure relating to addition, expansion, improvement
and alteration to the fixed
assets.
3. The replacement of fixed assets.
4. Research and development project.
Capital budgeting is a process where firms plan the investments
in long-term assets or activities
that have long-term financial implications. It involves a
substantial cash withdrawal and the cash
inflow is for a long period in the future. Just like other
decisions making process, capital
budgeting involves the considerations and valuation of available
alternatives. Among the
important matters that must be given attention in the valuation
process of capital budgeting
projects are the appropriate use of techniques and accurate
estimation of cash flow as inputs to
the techniques that will be used.
Definitions
According to the definition of Charles T. Hrongreen, “capital
budgeting is a long-term planning
for making and financing proposed capital out lays.
According to the definition of G.C. Philippatos, “capital
budgeting is concerned with the
allocation of the firms source financial resources among the
available opportunities. The
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consideration of investment opportunities involves the
comparison of the expected future streams
of earnings from a project with the immediate and subsequent
streams of earning from a project,
with the immediate and subsequent streams of expenditure”.
According to the definition of Richard and Green law, “capital
budgeting is acquiring inputs with
long-term return”.
According to the definition of Lyrich, “capital budgeting
consists in planning development of
available capital for the purpose of maximizing the long-term
profitability of the concern”.
It is clearly explained in the above definitions that a firm’s
scarce financial resources are
utilizing the available opportunities. The overall objectives of
the company from is to maximize
the profits and minimize the expenditure of cost.
Need and Importance of Capital Budgeting
1. Huge investments: Capital budgeting requires huge investments
of funds, but the
available funds are limited, therefore the firm before investing
projects, plan are control
its capital expenditure.
2. Long-term: Capital expenditure is long-term in nature or
permanent in nature. Therefore
financial risks involved in the investment decision are more. If
higher risks are involved,
it needs careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are
irreversible, are not changed back.
Once the decision is taken for purchasing a permanent asset, it
is very difficult to dispose
off those assets without involving huge losses.
4. Long-term effect: Capital budgeting not only reduces the cost
but also increases the
revenue in long-term and will bring significant changes in the
profit of the company by
avoiding over or more investment or under investment. Over
investments leads to be
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unable to utilize assets or over utilization of fixed assets.
Therefore before making the
investment, it is required carefully planning and analysis of
the project thoroughly.
CAPITAL BUDGETING PROCESS
Capital budgeting is a difficult process to the investment of
available funds. The benefit will
attain only in the near future but, the future is uncertain.
However, the following steps followed
for capital budgeting, then the process may be easier are.
1. Identification of various investments proposals: The capital
budgeting may have various
investment proposals. The proposal for the investment
opportunities may be defined from the top
management or may be even from the lower rank. The heads of
various department analyse the
various investment decisions, and will select proposals
submitted to the planning committee of
competent authority.
2. Screening or matching the proposals: The planning committee
will analyse the various
proposals and screenings. The selected proposals are considered
with the available resources of
the concern. Here resources referred as the financial part of
the proposal. This reduces the gap
between the resources and the investment cost.
3. Evaluation: After screening, the proposals are evaluated with
the help of various methods,
such as pay back period proposal, net discovered present value
method, accounting rate of return
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and risk analysis. Each method of evaluation used in detail in
the later part of this chapter. The
proposals are evaluated by.
a) Independent proposals
b) Contingent of dependent proposals
c) Partially exclusive proposals.
Independent proposals are not compared with another proposals
and the same may be accepted
or rejected. Whereas higher proposals acceptance depends upon
the other one or more proposals.
For example, the expansion of plant machinery leads to
constructing of new building, additional
manpower etc. Mutually exclusive projects are those which
competed with other proposals and
to implement the proposals after considering the risk and
return, market demand etc.
4. Fixing property: After the evolution, the planning committee
will predict which proposals will
give more profit or economic consideration. If the projects or
proposals are not suitable for the
concern’s financial condition, the projects are rejected without
considering other nature of the
proposals.
5. Final approval: The planning committee approves the final
proposals, with the help of the
following:
(a) Profitability
(b) Economic constituents
(c) Financial violability
(d) Market conditions.
The planning committee prepares the cost estimation and submits
to the management.
6. Implementing: The competent autherity spends the money and
implements the proposals.
While implementing the proposals, assign responsibilities to the
proposals, assign responsibilities
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for completing it, within the time allotted and reduce the cost
for this purpose. The network
techniques used such as PERT and CPM. It helps the management
for monitoring and containing
the implementation of the proposals.
7. Performance review of feedback: The final stage of capital
budgeting is actual results
compared with the standard results. The adverse or unfavourable
results identified and removing
the various difficulties of the project. This is helpful for the
future of the proposals.
KINDS OF CAPITAL BUDGETING DECISIONS
The overall objective of capital budgeting is to maximize the
profitability. If a firm concentrates
return on investment, this objective can be achieved either by
increasing the revenues or
reducing the costs. The increasing revenues can be achieved by
expansion or the size of
operations by adding a new product line. Reducing costs mean
representing obsolete return on
assets.
Capital budgeting refers to the technique used for analysing
whether an investment in an asset or
long-term project is profitable or not profitable. These
techniques are often mentioned as the
criteria of capital budgeting. There are four basic techniques
in capital budgeting; which are:
➢ Payback period technique
➢ Net present value technique
➢ Internal rate of return technique
➢ Profitability index
PAYBACK PERIOD
The payback period technique involves the use of payback period
criteria as the basis in decision
making. The payback period, normally referred with the acronym
PBP, is the time period taken
by a project to regain the sum of money invested at the
beginning of the project.
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Calculation of Payback Period
Examples 6.1 to 6.3 show how the payback period (PBP) is
obtained.
Example 6.1
Project A has the following cash flow. What is the PBP of this
project?
The negative cash flow of MVR100,000 at year 0 equals the total
that was invested, or the cash
outflow as the money has been spent on this project. Observe
that in the fourth year, the
cumulative cash inflow is MVR100,000, matching the cash outflow
(initial capital) at year 0.
Therefore, the PBP for Project A is 4 years, that is the time
where the total sum obtained matches
the total sum withdrawn.
Example 6.2
When PBP is between two different time periods, we can assume
that the distribution of cash
flow is uniform. In this situation, we can use the linear
interpolation to estimate the PBP for the
project assessed.
The project of purchasing a grinding machine has a cash flow as
follows:
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Based on the above cash flow, the PBP for this project is found
to be within 3 years to 4 years
because to achieve PBP, the cash inflow must be equal to the
cash outflow at the beginning of
this project that is MVR200,000. At the third year, the
cumulative cash inflow of MVR170,000
is still short of MVR30,000 (MVR200,000 - MVR170,000) to achieve
the PBP. By estimating
that the cash flow distribution is uniform, the calculation of
PBP for the project of purchasing a
grinding machine is as follows:
Note: MVR30,000 is the remaining balance that need to be
recovered.
For projects that generate cash flow in the form of annuity, you
can use formula 6.1 to calculate
the PBP.
Example 6.3
Suppose there is a project that involves a cash outflow of
MVR700,000 and it is expected to
produce a cash inflow of MVR200,000 every year throughout the
lifetime of the project, which
is 5 years. By using formula 6.1, the PBP of this project
is:
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= MVR700,000/MVR200,000
= 3.5 years
By using the cash flow schedule, we can also obtain the same
answer, which is PBP = 3.5 years.
Application of Payback Period
After knowing what is meant by PBP and how it is calculated, the
next step is to use this
technique in making decisions, whether to accept or reject a
capital budgeting project.
If a comparison is made between two projects with different PBP,
the project with the lower PBP
value is better as the company will regain its invested capital
faster. Therefore, the company will
have the opportunity to use that cash for other investing
purposes. Besides that, a shorter PBP
shows that the period where the company is exposed to investment
risks is also shorter.
In deciding whether to accept or reject a project, the company
must compare the PBP of the
project with the targeted PBP set by the company. This technique
proposed that a project will be
rejected if the PBP of that project is longer than the targeted
PBP and vice versa, that is, the
project should be accepted if the PBP of that project is less
than the targeted PBP. By referring to
example 6.1, if the company involved had set the targeted PBP
for the project at 3 years, the PBP
technique proposed that project A to be rejected as the PBP of
project A of 4 years exceeded the
targeted PBP of 3 years.
The criteria for accepting or rejecting a capital budgeting
project can be summarised as follows:
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Accept project if PBP ≤ targeted PBP
Reject project if PBP > targeted PBP
What is important is to evaluate whether the PBP of the project
is less or more than the targeted
PBP. The manager also need not calculate the PBP of the project
accurately as it is important to
ensure whether the PBP of the project is higher or lower than
the targeted PBP. To evaluate
whether the PBP of the project is higher or lower than the
targeted PBP, we only need to
determine whether the cumulative cash inflow of the targeted PBP
is higher or lower than the
initial cash outflow.
Example 6.4
Suppose that the targeted PBP for the project in example 6.2 is
4 years. Should the company
purchase the grinding machine?
Solution
The cumulative cash inflow at year 4, which is at the targeted
PBP, is MVR240,000. As this total
is more than the initial cash outflow of MVR200,000, therefore
it can be concluded that the PBP
of the grinding machine is higher than the targeted PBP. Based
on the PBP technique, the
grinding machine should be purchased.
Advantages and Disadvantages of Payback Period
The main advantages of using the PBP technique are as
follows:
a) PBP is easy to calculate and understand.
b) PBP uses the cash flows and not accounting profits as the
basis of calculation. The use of
cash flow as the basis of calculation is more accurate as it
shows the income and cost
involved and also clearly shows the time when the cash flow
occurs.
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c) The criteria of PBP is an indication of the liquidity for the
project. A shorter PBP shows
that the period where the funds are tied to a project is
shorter.
d) The criteria of PBP also takes into account the risk of a
project. A cash flow that is
distant has higher uncertainties. Therefore, the company should
focus on a lower PBP to
reduce risk that may be faced by the company.
However, the PBP technique has two main disadvantages, which
are:
(a) PBP Does Not Take into Account the Concept of Time Value of
Money
The cumulative cash inflow is obtained by totalling the cash
flow at different times without
making any adjustments to the time value of money. An analysis
that does not take into account
the time value of money concept, implicitly assumes that the
opportunity cost of the funds is 0.
Further explanation on this disadvantage is shown in the
following example.
Example 6.5
Referring to the above schedule, both these projects have the
same PBP that is in the second
year. This means that both these projects should be given the
same priority if PBP is applied.
Based on the concept of time value of money, we know that
project A is better than project B
because it produces an extra cash flow of MVR20,000 (MVR60,000 -
MVR40,000) in the first
year compared to project B. This extra cash flow can be
reinvested to generate returns. As PBP
does not take into account the time value of money, the use of
this technique is limited.
Therefore, the finance manager should not merely depend on the
PBP technique in making major
investment decisions. However, this disadvantage can be overcome
by using a discounted
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payback period technique. A discounted payback period technique
determines the period that is
required to regain the sum of money invested but the cash inflow
is discounted to the present
value before making decision on whether to accept or reject a
project.
(b) PBP Does Not Take into Account the Cash Flows After the
Payback Period One of the
disadvantages of the PBP technique is that it disregards the
cash flow after the payback period.
Thus, long term projects cannot be valued accurately. This
disadvantage can be shown in the
example.
Example 6.6
Based on PBP, project A is better than project B because the PBP
for project A is shorter than
project B (2 years compared to 4 years). If the targeted PBP is
not more than 2 years, the PBP
technique would accept project A and reject project B even
though project B generates cash flow
after the targeted PBP. By not taking into account the cash flow
after the payback period, the
company may disregard other better and more profitable
investments merely because it does not
fulfil the targeted PBP.
NET PRESENT VALUE
Net present value is a technique for making decisions in capital
budgeting that is based on the
criteria of net present value, simplified as NPV. It is one of
the techniques of discounted cash
flow as it uses the cash flow that has been adjusted for the
time value of money.
Calculation of Net Present Value
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Net Present Value (NPV) is the difference between the present
value of cash inflow with the
present value of cash outflow in a project. As the cash outflow
for a capital budgeting project
usually occurs at the beginning of a project, the formula for
NPV is stated as follows:
Example 6.7
A project has a cost of capital of 15% and the cash flow is as
follows:
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Example 6.8
If a project has a cash inflow that is in the form of annuity,
the calculation for NPV is easier and
simpler as you can use the present value factor annuity in your
calculations.
Suppose a project involves the initial investment cost of MVR 1
million. It is expected to
produce a cash flow of MVR 250,000 per year for 5 years. If the
cost of capital for this project is
12%, the NPV for this project is:
Application of Net Present Value
NPV of a project shows the amount of increase or decrease in the
value of a firm that is caused
by the investment in the project. NPV that is equivalent to zero
shows that the value of the firm
is maintained. A positive NPV will increase the value of the
firm while a negative NPV will
decrease the value of the firm.
Based on the explanation above, a project should be accepted if
the NPV is positive and should
be rejected if the NPV is negative. Therefore, the project in
Example 6.7 should be accepted
while the project in Example 6.8 should be rejected.
The criteria for rejecting/accepting an investment decision
based on this technique of net present
value can be summarised as follows:
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➢ If the projects that are evaluated are independent projects,
accept the projects that have
NPV ≥ 0.
➢ If the projects that are evaluated are mutually exclusive
projects, accept the projects that
have the highest NPV and NPV ≥ 0
Advantages and Disadvantages of Net Present Value
The advantages of the NPV technique are as follows:
(a) It uses the cash flow and not accounting profits.
(b) It takes into account the timing of cash flow by using the
discounted cash flow or the concept
of time value of money.
(c) It takes into account all the cash flows of the project.
(d) The criteria of NPV is in accordance with the concept of
owner’s wealth where, in theory,
NPV of a project represents the explicit measurement of the
increase or decrease of a firm’s
value and owner’s wealth. Therefore, the NPV technique is the
best technique in the perspective
of financial theory.
Disadvantages of the NPV technique are as follows:
(a) The calculation of NPV is rather complex compared to PBP
because it requires an in depth
understanding of the concept and calculation of present
value.
(b) The calculation of NPV requires information on the cost of
capital for the project that is
sometimes difficult to ascertain.
INTERNAL RATE OF RETURN
This technique uses the criteria known as the internal rate of
return as the evaluation basis in
capital budgeting project.
Calculation of Internal Rate of Return
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The internal rate of return (IRR) of a project is defined as the
rate of discount that equates the
present value of cash inflow with the initial cash flow, or the
rate of discount when the NPV is
equal to zero.
It is calculated using the following mathematical equation:
The manual calculation of IRR involves a process of trial and
error and linear interpolation.
Example 6.9 shows the calculations involved in using the above
equation.
Example 6.9
Two projects have the following cash flows:
Manually, you would have to use the trial and error method,
where you would include a discount
rate (k) and see whether NPV is equal to 0 or not. You might
have to do this process several
times until you obtain k when NPV is equal to 0 (Whenever
possible, you should try until you
obtain a positive number and a negative number). There is a
bigger possibility that it would
involve a linear interpolation where the IRR is not a whole
number. Calculators and certain
computer packages can be used to help calculate the IRR that is
not a whole number.
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Application of Internal Rate of Return
IRR is the expected rate of return that will be obtained by a
firm if a project is accepted
meanwhile the cost of capital, k, is the required rate of return
from the project to maintain its
value. If the IRR of the project is higher than k, then the
value of the firm will increase and vice-
versa, the value of the firm will fall when the IRR is lower
than k. The value of the firm will not
change if the IRR is equal to k.
In summary, the criteria for acceptance and rejection of a
project based on the IRR are as
follows:
❖ If the projects evaluated are independent projects, accept the
project that have IRR cost of
capital.
❖ If the projects evaluated are mutually exclusive projects,
accept the project with the
highest IRR and between the projects that have at least an IRR
equal to the cost of
capital.
Referring to the projects in example 6.9, if the cost of capital
is 14%, project A will be accepted
while project B will be rejected.
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Advantages and Disadvantages of Internal Rate of Return
After understanding what is IRR and how it is applied, now we
will look at the advantages and
disadvantages of IRR.
The advantages of IRR are as follows:
a) Just like the criteria of PBP and NPV, IRR uses the cash flow
and not accounting profits
as the basis for calculations.
b) Just like the criteria of NPV, the IRR takes into account the
time value of money in its
calculations.
c) In a lot of situations, the IRR technique provides a solution
that is parallel with the NPV
technique. The IRR technique is acknowledged to be the best
technique in the perspective
of financial theory. This is because when a project has IRR more
than k, its NPV is also
more than 0.
▪ If k > IRR, NPV < 0 ; project should be rejected.
▪ If k < IRR, NPV > 0; project should be accepted.
▪ If k = IRR, NPV = 0; project should be accepted.
The disadvantages of IRR are as follows:
a) The calculation of IRR is more complicated compared to
NPV.
b) The calculation of IRR requires information on the cost of
capital of the project which is
rather difficult to ascertain.
c) Decisions are difficult to make when IRR is multiple, which
is a situation where the
solution of the mathematical equation for IRR gives more than
one answer. This situation
will be faced in the consideration of projects that are
unconventional. Conventional
projects are defined as projects where the cash outflow only
happens in the beginning of
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the project while in the following years, the project will
generate cash inflows. The signal
for this cash flow has the following pattern: - + + + + +. For
projects that are
unconventional, the cash outflow can occur in the middle of a
series of cash inflows, for
example, projects that have the following cash flow pattern: - +
+ - + + - + +. The number
of IRR for such projects is the same with the number of the cash
flow direction change, in
this example, its number is five.
PROFITABILITY INDEX
The technique of profitability index or PI uses the criteria
that is known as profitability index
as the evaluation basis for capital budgeting projects.
Calculation of Profitability Index Just
like the NPV, the Profitability Index (PI) uses a discounted
cash flow as the evaluation basis.
Therefore, it is grouped in the criteria of discounted cash
flow.
PI is defined as the present value per Ringgit of investment and
is a type of benefit-cost ratio.
The PI calculation requires an input similar to the calculation
of NPV. If we return to the
project in example 6.8, we will find that the project PI is
0.90125, which is MVR 901,250
divided by MVR 1,000,000.
Application of Profitability Index
In principle, a project is profitable if its benefit exceeds its
cost. The general rule for
Profitability Index (PI) is that the project should be accepted
if the PI is the same with or
more than 1. As we have discussed, the value of the firm will
increase if the NPV is positive.
Observe that a positive NPV is the same with the situation where
the PI is more than 1. In
accordance to this, the value of the firm will increase if the
PI is more than 1. Therefore, the
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PI technique encourages the project to be accepted if the PI is
more than one and rejected if
the PI is less than 1.
In summary, the criteria for acceptance/rejection are as
follows:
• Accept the project if PI ≥ 1
• Reject the project if PI < 1
• If PI = 0, the project will have no effect on the wealth of
the company.
Therefore, the acceptance or rejection of the project will not
have any effect on the company.
Advantages and Disadvantages of Profitability Index
In summary, the PI has advantages and disadvantages that are
almost the same with the NPV
technique. Its disadvantage compared to the NPV is that it does
not measure the total increase
in wealth, as measured by the NPV. It also has an advantage
where it is used together with
the NPV to make decisions in situations where the investment
capital of the firm is limited.
………………… END………………...
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Practice Questions
Question 1
You are considering the following two projects:
Project A
Requires an initial investment of MVR250,000 and this project
will generate cash inflow of
MVR100,000 at the end of the second and third year and
MVR150,000 at the end of the fourth
year.
Project B
Requires an initial investment of MVR400,000 and this project
will produce cash inflow of
MVR125,000 every year for five years.
Based on the PBP technique, should these projects be accepted if
the targeted payback period is
3 years?
Question 2
Calculate the payback period for a project that involves the
initial cash outflow of MVR1 million
and an annual cash inflow of MVR100,000 for the first five years
and MVR200,000 for the next
five years.
Question 3
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Question 4
Question 5
Question 6
The opening of a mini market involves a cost of MVR300,000 as
the initial capital. It is expected
that the mini market will generate a cash flow of MVR20,000
every year for a period of five
years. At the end of the fifth year, the mini market can be sold
to generate a cash flow of
MVR400,000. What is the NPV if the cost of capital is equivalent
to 10%?
Question 7
When the cost of capital increases, the NPV of the project will
________________.
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Question 8
Question 9
Question 10
Voltex Company is considering a new project. This project will
involve an initial investment of
MVR1,200,000 and will produce MVR600,000 cash flow every year
for 3 years. Calculate the
IRR of this project.
A. 14.5%
B. 18.6%
C. 23.4%
D. 20.2%
Question 11
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Question 12
Question 13
A project has an initial cash outflow of MVR10,000 that produces
a single cash flow of
MVR16,650 in year 1. If the cost of capital is 12%, calculate
the:
(a) Payback period
(b) Net present value
(c) Internal rate of return
Question 14
A project has an initial cash outflow of RM10,000 and produces a
cash inflow of RM2,146 every
year for the next ten years. If the cost of capital is equal to
12%, calculate the:
(a) Payback period
(b) Net present value
(c) Internal rate of return
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Question 15
A project has the initial cash outflow of MVR10,000 and produces
cash inflow of MVR3,000 at
the end of the first year, MVR5,000 at the end of the second
year and MVR7,500 at the end of
the third year. If the cost of capital is equal to 12%,
calculate the:
(a) Payback period
(b) Net present value
(c) Internal rate of return
Question 16
Bina Company is evaluating two projects of constructing two
different luxury apartments in two
towns in the state of Kedah. The initial investment for both
projects are equal, that is
MVR160,000. The required rate of return for these projects is
10%. The following is the
estimated annual cash flow for the first 6 years.
Based on the above information, you are required to make an
analysis for the decision on capital
budgeting based on these techniques:
(a) Payback period
(b) Net present value
Question 17
List one advantage and one disadvantage that is unique for each
of the following capital
budgeting evaluation techniques:
(a) Payback period
(b) Net present value
(c) Internal rate of return
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Question 18
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Question 19
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Question 20
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Question 21
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Question 22
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Question 23
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Question 24
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Question 25
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Question 26
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Question 27
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Question 28
Question 29
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Question 30
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Question 31
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Question 32
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Question 33
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Question 34
Question 35
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Question 36
Question 37
A firm is considering investing in a project with the following
cash flows:
Year 1 2 3 4 5 6 7 8
Net cash
flow ($) 2,000 3,000 4,000 3,500 3,000 2,000 1,000 1,000
The project requires an initial investment of $12,500, and the
firm has a required rate of
return of 10 percent. Compute the payback, and net present
value, and determine whether the
project should be accepted.
Question 38
The management of Health Supplement Inc. wants to reduce its
labor cost by installing a new
machine. Two types of machines are available in the market –
machine X and machine Y.
Machine X would cost $18,000 where as machine Y would cost
$15,000. Both the machines can
reduce annual labor cost by $3,000.
Required: Which is the best machine to purchase according to
payback method?
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Question 39
Certain projects require an initial cash outflow of MVR 25,000.
The cash inflows for 6 years are
MVR 5,000, MVR 8,000, MVR 10,000, MVR 12,000, MVR 7,000 and MVR
3,000. Calculate
PBP?
Question 40
Calculate PBP.
Question 41
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Question 42
Question 43
A project costs Rs. 16,000 and is expected to generate cash
inflows of Rs. 4,000 each 5 years.
Calculate the Interest Rate of Return.
Question 44
Let us assume that a firm has only Rs. 20 lakhs to invest and
funds cannot be provided. The
various proposals along with the cost and profitability index
are as follows.
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Question 45
Question 46
Calculate internal rate of return and suggest whether the
project should be accepted of cost.
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Question 47
Question 48
Question 49
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Question 50
Question 51
Question 52
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Question 53
Question 54
Question 55
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Question 56
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Question 57
Question 58
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Question 59
Question 60
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Question 61
Using the discount table provided, calculate the Net Present
Value (NPV) of the project and
advise whether the company should invest in it.
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Question 62
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Question 63
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Question 64
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Question 65
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Question 66
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Question 67
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Question 68
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Question 69
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Question 70